2004
  ANNUAL
FINANCIAL
   REPORT
CONTENTS

NASD MANAGEMENT REPORT ON FINANCIAL OPERATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....
NASD
MANAGEMENT REPORT ON FINANCIAL OPERATIONS

OVERVIEW

NASD is the leading private-sector provider of financial regulat...
2004 YEAR-IN-REVIEW

2004 marked another successful year for NASD in its goal to solidify its leadership position as the p...
RESULTS OF OPERATIONS

REVENUES

The following table sets forth consolidated revenues by segment and revenue category:

NA...
USER FEES include fees charged for initial and annual registrations, qualifications exams, fees associated with NASD spons...
$365.8 million in 2003. This decline is due mainly to a reduction in Section 31 rates charged by the SEC in 2004. In Augus...
NASD

NASD total expenses were $564.0 million in 2004 compared with $518.2 million in 2003, an increase of $45.8 million i...
CONSOLIDATING ADJUSTMENTS
Consolidating adjustments represent the elimination of intercompany charges at the Company level...
P R O V I S I O N FO R I N C O M E T A X E S
As NASD is a tax-exempt organization under the provisions of the Internal Rev...
accounting, and (c) how the arrangement consideration should be allocated among the separate units of accounting. Once eac...
See table below for total cash flows by segment between years:
                                                           ...
CONTRACTUAL OBLIGATIONS AND CONTINGENT COMMITMENTS

The Company has contractual obligations to make future payments under ...
With its 54.7 percent ownership and one share of Series B Preferred Stock, NASD continues to exert voting control over NAS...
Warrants to purchase NASDAQ common shares are exercisable in four annual tranches. As of December 31, 2004, the first two
...
NASD maintains a portion of its portfolio in equity securities, which have been more sensitive to market fluctuations. NAS...
under revenue sharing arrangements with market participants. Pursuant to EITF No. 99-19, “Reporting Revenues Gross vs. Net...
NASD recovers the cost of the SEC’s fees and assessments through an activity assessment billed to securities firms based o...
RECENT ACCOUNTING PRONOUNCEMENTS

In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123 (r...
CERTIFICATION FOR 2004 ANNUAL FINANCIAL REPORT
We, Robert R. Glauber and Todd T. Diganci, certify that:
    1.   We have r...
AUDIT COMMITTEE REPORT
In accordance with its written Charter adopted by the Board of Governors, the Audit Committee of th...
(3) Tax services represent fees related to tax compliance, advice, and planning.
(4) For 2003, other services for NASDAQ r...
REPORT OF INDEPENDENT AUDITORS

BOARD O F GOVERNORS

NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC.


We have audited th...
NASD
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS)

                                                                 ...
NASD
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS)

                                                                 ...
NASD
CONSOLIDATED STATEMENTS OF INCOME
(DOLLARS IN THOUSANDS)
                                                            ...
NASD
CONSOLIDATED STATEMENTS OF CHANGES IN MEMBERS’ EQUITY
(DOLLARS IN THOUSANDS)

                                       ...
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  1. 1. 2004 ANNUAL FINANCIAL REPORT
  2. 2. CONTENTS NASD MANAGEMENT REPORT ON FINANCIAL OPERATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 CERTIFICATION FOR 2004 ANNUAL FINANCIAL REPORT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19 AUDIT COMMITTEE REPORT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20 REPORT OF INDEPENDENT AUDITORS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22 2004 CONSOLIDATED FINANCIAL STATEMENTS: CONSOLIDATED BALANCE SHEETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23 CONSOLIDATED STATEMENTS OF INCOME . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25 CONSOLIDATED STATEMENTS OF CHANGES IN MEMBERS’ EQUITY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26 CONSOLIDATED STATEMENTS OF CASH FLOWS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29 NASD BOARDS AND COMMITTEES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .81 CORPORATE OFFICERS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .91 CORPORATE OFFICES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .94 NASD 2 004 ANNUAL FINANCIAL REPORT 1
  3. 3. NASD MANAGEMENT REPORT ON FINANCIAL OPERATIONS OVERVIEW NASD is the leading private-sector provider of financial regulatory services, dedicated to investor protection and market integrity through effective and efficient regulation. NASD touches virtually every aspect of the securities business—from registering all industry participants, to examining securities firms, enforcing both NASD rules and the federal securities laws, and administering the largest dispute resolution forum for investors and firms. The following discussion and analysis of financial condition and results of operations should be read in connection with the consolidated financial statements and notes thereto included elsewhere in this Annual Financial Report. The 2004 consolidated financial statements reflect the combined activity of NASD and its consolidated subsidiaries, The Nasdaq Stock Market, Inc. (NASDAQ); NASD Regulation, Inc. (NASDR); NASD Dispute Resolution, Inc. (NASD DR); NASD Investor Education Foundation (NIEF); and New NASD Holding, Inc. (NASD Holding), which held NASD’s Class B interest in The American Stock Exchange LLC (Amex). On December 31, 2004, NASD completed the sale of its Class B ownership interest in Amex to the Amex Membership Corporation. Amex results have been reported as a discontinued operation in the consolidated financial statements. (References to NASD and its consolidated subsidiaries throughout are collectively referred to as “the Company.”) The Company views its business as consisting of two segments as defined by Statement of Financial Accounting Standards (SFAS) No. 131, “Disclosures About Segments of an Enterprise and Related Information.” These segments, NASD and NASDAQ, are managed and operated as separate, stand-alone companies, each with its own corporate governance. NASD consists of regulatory operations, and is a self-regulatory organization (SRO). NASDAQ consists of the operations of The NASDAQ Stock Market. While this report reflects the consolidated operations of the Company, the primary focus is on the NASD segment, including NASDR and NASD DR. This focus is consistent with the steps the Company has taken to divest itself of ownership and operation of securities markets and is intended to highlight discussion of areas that will remain with NASD upon completion of the NASDAQ separation. For the year ended December 31, 2004, the Company’s consolidated net income was $66.5 million compared with a net loss of $57.7 million in 2003. Included in the 2004 results is a cumulative effect of a change in accounting principle of $58.3 million and income from discontinued operations of $19.7 million. Income from continuing operations was $105.1 million in 2004 compared with $50.0 million in 2003. 2 NASD 2004 ANNUAL FINANCIAL REPORT
  4. 4. 2004 YEAR-IN-REVIEW 2004 marked another successful year for NASD in its goal to solidify its leadership position as the preeminent U.S. private sector regulator in the financial services industry. NASD completed the sale of Amex to the Amex Membership Corporation, further separating itself from ownership and operation of stock exchanges. NASD and NASDAQ made significant strides toward further reducing NASD’s ownership of NASDAQ common stock and worked closely on other steps to better position both organizations for operation once the Securities and Exchange Commission (SEC) approves NASDAQ’s Exchange Registration. In February 2005, NASDAQ completed an underwritten secondary offering including 16.6 million shares of common stock previously owned by NASD. As a result of this transaction, NASD’s economic ownership interest in NASDAQ has been reduced to 33.7 percent. 2004 highlights for NASD in fulfilling its mission of investor protection and market integrity: • Filed 1,396 enforcement actions, barring or suspending 833 individuals, and levying and collecting more than $103.9 million in disciplinary fines. • Dramatically increased transparency in the corporate debt market through the dissemination of transaction information on corporate bonds reported through NASD’s Trade Reporting and Compliance Engine (TRACE) to 22,000 bonds, or more than 98 percent of the investment grade market. NASD brought full transparency to the corporate bond market in February of 2005. • Dispute Resolution closed the year with 8,201 claims filed in arbitration and 1,217 mediation cases in agreement. The forum also closed 9,209 cases, an all-time record. NASD opened seven new hearing locations across the United States. By March 2005, Dispute Resolution had established at least one hearing location in each of the 50 states. • Funded the newly created NIEF with an initial endowment of $10.0 million in March of 2004. NIEF will provide grants for educational programs and materials for the investing public. • NASD, together with the SEC, settled a major mutual fund sales practice case against First Command Financial Planning, Inc. (First Command), a Texas-based firm that specialized in selling expensive systematic investment plans to military personnel. First Command paid a $12.0 million fine, and NASD directed its portion of the fine to be paid directly to the NIEF to support educational programs, materials, and research to help equip members of the military community with the knowledge and skills necessary to make informed investment decisions. • In the area of rule writing, NASD moved forward with a number of important investor-focused proposals that touched on nearly every aspect of the securities industry, including variable annuity suitability and other recommendation requirements; requirements for securities firms to establish emergency preparedness plans; and new rules to ensure that firms effectively monitor the activities of their employees, especially those who manage office locations and also conduct their own securities business. NASD also put in place a required annual certification by chief executive officers of securities firms that the firm has processes to establish, maintain, review, test, and modify written compliance policies and written supervisory procedures. NASD 2 004 ANNUAL FINANCIAL REPORT 3
  5. 5. RESULTS OF OPERATIONS REVENUES The following table sets forth consolidated revenues by segment and revenue category: NASD CONSOLIDATED NET REVENUES BY SEGMENT YEARS ENDED DECEMBER 31, 2004 2003 NASD NASDAQ Consolidating Consolidated NASD NASDAQ Consolidating Consolidated Adjustments Adjustments (in millions) Market services $ – $ 334.5 $ (2.0) $ 332.5 $ – $ 383.7 $ (0.1) $ 383.6 Issuer services – 205.8 (4.3) 201.5 – 204.2 – 204.2 Regulatory fees 222.8 – – 222.8 174.2 – – 174.2 User fees 137.3 – – 137.3 128.4 – – 128.4 Transparency services 14.7 – – 14.7 21.1 – – 21.1 Contract service fees 58.1 – (53.4) 4.7 63.1 – (60.5) 2.6 Dispute resolution fees 80.2 – – 80.2 75.5 – – 75.5 Other fees 8.9 0.1 (6.7) 2.3 9.7 1.9 (7.0) 4.6 Total operating revenues 522.0 540.4 (66.4) 996.0 472.0 589.8 (67.6) 994.2 Activity assessment 230.9 – – 230.9 365.8 – – 365.8 Fines 114.4 – – 114.4 33.3 – – 33.3 Total revenues 867.3 540.4 (66.4) 1,341.3 871.1 589.8 (67.6) 1,393.3 Cost of revenues (230.9) (55.8) – (286.7) (365.8) – – (365.8) Net revenue $ 636.4 $ 484.6 $ (66.4) $ 1,054.6 $ 505.3 $ 589.8 $ (67.6) $ 1,027.5 NASD NASD net revenues were $636.4 million in 2004 compared with $505.3 million in 2003, an increase of $131.1 million or 25.9 percent. REGULATORY FEES include the transaction-based trading activity fee, as well as assessments based on member firm gross income and number of personnel. Regulatory fees totaled $222.8 million in 2004 compared with $174.2 million in 2003, an increase of $48.6 million or 27.9 percent. Regulatory fees are used to fund NASD’s member regulatory activities, including the regulation of members through examinations, processing of membership applications, financial monitoring, policymaking, rulemaking, and enforcement activities. To ensure adequate funding levels for member regulatory programs, the rates charged for trading activity fee services were increased in September of 2003. Based on the increased rate structure and higher trading volumes in 2004, trading activity fees totaled $110.0 million in 2004 as compared with $70.9 million in 2003. Further contributing to the increase in regulatory fees were personnel assessments, which totaled $33.3 million in 2004 as compared with $20.5 million in 2003. The increase in personnel assessments between years was driven by a planned three-year phase-in approved by the SEC in 2002. In November 2004, the trading activity fee rates were also reduced as part of this three-year phase in of regulatory fee pricing changes. These revenue changes have been instituted to better align NASD’s regulatory fees with its functions, efforts, and costs. 4 NASD 2004 ANNUAL FINANCIAL REPORT
  6. 6. USER FEES include fees charged for initial and annual registrations, qualifications exams, fees associated with NASD sponsored meetings and conferences, and charges associated with the review of underwriting arrangements in corporate filings. User fees totaled $137.3 million in 2004 compared with $128.4 million in 2003, an increase of $8.9 million or 6.9 percent. This increase was primarily attributable to an increase in the number of corporate filings and increase in the average size of filings reviewed. As a result, corporate financing revenues increased $5.9 million or 58.1 percent over 2003 levels. Further contributing to higher user fee revenues were an increase in the number of advertising filings reviewed and an increase in the number of conferences held by NASD’s education and training area. In 2004, in connection with the implementation of Emerging Issues Task Force (EITF) No. 00-21, “Revenue Arrangements with Multiple Deliverables,” NASD has separated first year registration fees into their initial and annual components and has begun to defer and amortize the initial fee component over an estimated customer relationship period. See the Cumulative Effect of a Change in Accounting Principle section for further discussion. TRANSPARENCY SERVICES represent fees charged for services offered through TRACE and NASD’s Alternative Display Facility (ADF). Transparency services revenues were $14.7 million in 2004 compared with $21.1 million in 2003, a decrease of $6.4 million or 30.3 percent. This decrease was due to the loss of ADF’s largest customer in February of 2004, which led to a decline in ADF market data fees from $7.8 million in 2003 to $1.7 million in 2004. TRACE, which began operation in 2002, represents fees charged on secondary market transactions in eligible fixed income securities reported to NASD, as well as TRACE system related fees, and TRACE market data fees. While TRACE average daily volumes were down slightly in 2004, the number of terminals receiving corporate debt information increased, yielding consistent revenue performance for TRACE between years. CONTRACT SERVICES FEES represent amounts charged for regulatory services provided primarily to NASDAQ and Amex, as well as other exchanges such as the International Stock Exchange and the Chicago Climate Exchange, associated with surveillance, monitoring, legal, and enforcement activities. Contract services fees totaled $58.1 million in 2004 compared with $63.1 million in 2003, a decrease of $5.0 million or 7.9 percent. This decrease was driven by lower depreciation charges and lower spending on NASDAQ initiatives, as well as a reduction in fees charged to NASDAQ due to a shift in the allocation of regulation resources between market and member regulation. Overall NASDAQ contract service fees declined from $61.8 million in 2003 to $45.6 million in 2004. Offsetting declines in NASDAQ contract service fees were new billings under the Amex Regulatory Services (RSA) agreement, which took effect in June 2004. Amex regulatory billings totaled $6.6 million in 2004. DISPUTE RESOLUTION FEES totaled $80.2 million in 2004 compared with $75.5 million in 2003. Dispute resolution closed 9,209 cases in 2004, an all time record, as compared with 7,278 in 2003. In 2004, in connection with the implementation of EITF No. 00-21, NASD changed its accounting for dispute resolution fees collected on open cases. See the Cumulative Effect of a Change in Accounting Principle section for further discussion. Also included within dispute resolution fees are mediation fees, SRO annual fees for forum services, neutral training fees, and other fees totaling $2.1 million and $1.7 million for the years ended December 31, 2004 and 2003, respectively. These fees are recognized either as the cash is received or when the service is provided. OTHER FEES totaled $8.9 million in 2004 as compared with $9.7 million in 2003. This slight decline is due to a decrease in amounts received from NASDAQ related to separation of NASDAQ and Amex shared technology applications. In 2002, a Master Agreement was signed between NASD, NASDAQ, and Amex whereby NASD and NASDAQ each agreed to reimburse Amex up to $14.5 million for costs incurred in the separation of technology applications. NASDAQ paid NASD $4.6 million in 2004 and $5.9 million in 2003 under this program. NASD then contributed those amounts, along with NASD’s matching portion, to Amex in the form of a capital contribution. As of December 31, 2004, this program was fully funded and no further contributions are pending from either NASD or NASDAQ. Payments from NASDAQ to NASD under this program are included in the intercompany eliminations in the consolidating adjustments column. ACTIVITY ASSESSMENT FEE AND COST OF REVENUES represent amounts incurred by NASD and owed to the SEC pursuant to Section 31 of the Securities and Exchange Act of 1934. Activity assessment fees totaled $230.9 million in 2004 as compared with NASD 2 004 ANNUAL FINANCIAL REPORT 5
  7. 7. $365.8 million in 2003. This decline is due mainly to a reduction in Section 31 rates charged by the SEC in 2004. In August 2004, the SEC adopted new rules under Section 31 and provided additional guidance as to how the SEC charges SROs for these fees. As a result of the clarifications in the new rules, NASD has begun reporting amounts owed under Section 31 on a gross basis in the consolidated financial statements in accordance with EITF No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent.” Balances for 2003 have also been reclassified to conform to current year presentation. FINES represent amounts billed as sanctions for rule violations, which NASD does not view to be part of operating revenues. Fines totaled $103.9 million cash collected and $114.4 million in total in 2004 compared with $33.3 million collected in 2003, an increase of $81.1 million or 243.5 percent. In 2004, NASD levied numerous large sanctions for issues ranging from improper mutual fund sales and trading practices to excessive mark-ups. NASDAQ NASDAQ net revenues declined $105.2 million from $589.8 million in 2003 to $484.6 million in 2004, due mainly to a decline in NASDAQ’s market share of transactions reported to NASDAQ’s systems, the effect of price reductions, elimination of certain fees, and the implementation of the NASDAQ General Revenue Sharing Program. CONSOLIDATING ADJUSTMENTS Consolidating adjustments represent the elimination of intercompany charges at the Company level, primarily contract services fees charged to NASDAQ and Amex. Beginning in 2005, Amex contract services will no longer be eliminated as the sale of Amex to Amex Membership Corporation was completed on December 31, 2004. TOTAL EXPENSES The following table summarizes total operating expenses by segment and category: NASD CONSOLIDATED EXPENSES BY SEGMENT YEARS ENDED DECEMBER 31, 2004 2003 NASD NASDAQ Consolidating Consolidated NASD NASDAQ Consolidating Consolidated Adjustments Adjustments (in millions) Compensation and benefits $ 306.8 $ 148.2 $ (0.2) $ 454.8 $ 267.8 $ 159.1 $ 0.2 $ 427.1 Professional and contract services 118.5 23.7 (3.0) 139.2 116.6 37.5 (0.7) 153.4 Computer operations and data communications 24.8 98.9 (0.3) 123.4 19.1 125.6 – 144.7 Depreciation and amortization 39.5 76.3 0.1 115.9 47.3 90.0 – 137.3 Occupancy 30.4 28.7 – 59.1 30.1 31.2 – 61.3 General and administrative 44.0 100.6 (40.2) 104.4 37.3 110.9 (58.0) 90.2 Elimination of non-core products – – – – – 97.9 – 97.9 NASDAQ Japan impairment gain – – – – – (5.0) – (5.0) Total expenses $ 564.0 $ 476.4 $ (43.6) $ 996.8 $ 518.2 $ 647.2 $ (58.5) $ 1,106.9 6 NASD 2004 ANNUAL FINANCIAL REPORT
  8. 8. NASD NASD total expenses were $564.0 million in 2004 compared with $518.2 million in 2003, an increase of $45.8 million in 2004 or 8.8 percent. COMPENSATION AND BENEFITS increased $39.0 million or 14.6 percent from $267.8 million to $306.8 million due to an increase in the number of member regulation, enforcement, and dispute resolution personnel, as well as headcount increases to service the Amex RSA. Total NASD head count was 2,333 as of December 31, 2004 compared with 2,085 as of December 31, 2003. Also contributing to the expense increase were costs associated with the Company’s defined benefit pension plans due to continued reductions in the interest rate environment. PROFESSIONAL AND CONTRACT SERVICES remained relatively consistent between years at $118.5 million in 2004 compared to $116.6 million in 2003. Included within this overall consistent performance were increases in arbitrator payments and NASD conference expenses offset by a reduction in consulting services due to a continuing disciplined approach to the review and approval of new initiative spending. COMPUTER OPERATIONS AND DATA COMMUNICATIONS totaled $24.8 million in 2004 compared to $19.1 million in 2003, an increase of $5.7 million or 29.8 percent. This increase was attributable to new communication lines established for ADF and TRACE in 2004, as well as additional operational costs associated with several server migrations. DEPRECIATION AND AMORTIZATION totaled $39.5 million in 2004 compared with $47.3 million in 2003, a decline of $7.8 million or 16.5 percent. This decline was due primarily to several assets becoming fully depreciated in the prior year. NASD has also significantly curtailed its capital spending in recent years with the reduction in cost of technology equipment and efficient management of the existing technology environment. OCCUPANCY expense remained consistent between years at $30.4 million in 2004 compared with $30.1 million in 2003. GENERAL AND ADMINISTRATIVE expenses include the company’s expenditures on matters such as travel, supplies, and marketing. General and administrative expenses totaled $44.0 million in 2004 compared with $37.3 million in 2003, an increase of $6.7 million or 18.0 percent. The majority of this increase relates to bad debt expense on outstanding fines receivable as of December 31, 2004, impairment recorded on software replaced in the current year, and a loss on disposal of fixed assets associated with the migration of NASD servers in 2004. Offsetting this increase was a decline in marketing expenses due to NASD’s mutual fund breakpoint campaign, which took place during the fourth quarter of 2003. NASD recognized $3.9 million of expense in 2003 associated with this public awareness campaign. NASDAQ Overall, NASDAQ total expenses declined significantly from 2003 to 2004. Total expenses in 2004 were $476.4 million as compared with $647.2 million in 2003, a decrease of $170.8 million or 26.4 percent. This significant decline represents a series of large one-time charges taken by NASDAQ in 2003 in connection with its strategic review and elimination of non-core product lines combined with the ongoing effects of these cost reductions in 2004. In 2003, NASDAQ incurred $97.9 million in charges associated with the elimination of non-core product lines. In 2004, the cost savings from these actions were realized. In addition, NASDAQ continued its cost cutting measures, eliminating an additional 172 positions and reducing its overall headcount from 956 on December 31, 2003 to 786 on December 31, 2004. NASD 2 004 ANNUAL FINANCIAL REPORT 7
  9. 9. CONSOLIDATING ADJUSTMENTS Consolidating adjustments represent the elimination of intercompany charges at the Company level, primarily contract services fees charged by NASD to NASDAQ and Amex. Beginning in 2005, Amex contract services will no longer be eliminated, as the sale of Amex to Amex Membership Corporation was completed on December 31, 2004. OTHER I NCOME ( EXPENSE) The following table summarizes total other income (expense) by segment and category: NASD CONSOLIDATED OTHER INCOME (EXPENSE) BY SEGMENT YEARS ENDED DECEMBER 31, 2004 2003 NASD NASDAQ Consolidating Consolidated NASD NASDAQ Consolidating Consolidated Adjustments Adjustments (in millions) Interest and dividend income $ 42.7 $ 5.9 $ (13.2) $ 35.4 $ 42.0 $ 9.5 $ (8.1) $ 43.4 Interest expense (0.3) (11.5) – (11.8) (0.1) (18.6) – (18.7) Net realized investment gains 25.7 – – 25.7 24.6 – (0.3) 24.3 Gain on Nasdaq warrants 3.9 – – 3.9 16.1 – – 16.1 Net losses from equity investees – – – – – – (4.1) (4.1) Minority interest benefit (expense) – – (5.1) (5.1) – – 47.2 47.2 Total other income (expense) $ 72.0 $ (5.6) $ (18.3) $ 48.1 $ 82.6 $ (9.1) $ 34.7 $ 108.2 NASD NASD total other income was $72.0 million in 2004 compared with $82.6 million in 2003, a decline of $10.6 million or 12.8 percent. This decline between years is primarily attributable to a reduction in the gain recognized on the change in value of warrants to purchase NASDAQ stock from NASD. These warrants are carried at fair value with changes in the fair value recorded in income. The fair value of these warrants is calculated using a Black-Scholes valuation model. The decline in gain recognized between years is reflective of the passage of time and expiration of additional warrant tranches. NASDAQ NASDAQ realized a decline in other expense between periods due mainly to the redemption of outstanding debt in the third quarter of 2003. In 2003, NASDAQ redeemed the $150.0 million outstanding principal amount of senior notes due in 2007. CONSOLIDATING ADJUSTMENTS Consolidating adjustments represent mainly the intercompany elimination of dividends on NASDAQ preferred stock recognized by NASD, as well as NASD’s sharing of income and losses in NASDAQ with minority interest partners. Minority interest expense (benefit) increased from a benefit of $47.2 million in 2003 to an expense of $5.1 million in 2004, reflective of the minority interest partners’ share of NASDAQ’s net loss in 2003 and net income in 2004. 8 NASD 2004 ANNUAL FINANCIAL REPORT
  10. 10. P R O V I S I O N FO R I N C O M E T A X E S As NASD is a tax-exempt organization under the provisions of the Internal Revenue Code Section 501(c)(6), tax expenses reflected in the Company’s consolidated financial statements represent the tax expense of NASDAQ. NASDAQ recorded a tax provision from continuing operations in 2004, with an effective tax rate of 29.3 percent, and a tax benefit from continuing operations in 2003, with an effective tax rate of 32.0 percent. The change from a tax benefit in 2003 to a tax provision in 2004 is related to the net loss reported by NASDAQ in 2003 versus net income reported for 2004. DISCONTINUED OPERATIONS Discontinued operations in the Company’s consolidated statements reflect charges taken by both NASD Holding and NASDAQ. See the table below for a breakdown by company by year. YEARS ENDED DECEMBER 31, 2004 2003 (in millions) Discontinued Operations: NASD Holding $ 10.1 $ (47.4) NASDAQ 9.6 (60.3) Total $ 19.7 $ (107.7) NASD NASD Holding’s net loss from discontinued operations represents the operations of Amex for the period, net of intercompany eliminations and taxes, as well as the estimated loss at disposal recorded as of December 31, 2004, and 2003. On October 31, 2003, NASD agreed in principle to sell its ownership interest in Amex to the Amex Membership Corporation. On December 31, 2004, NASD completed the sale of Amex to the members of Amex Membership Corporation. See Note 16, “Discontinued Operations,” to the consolidated financial statements for further discussion. NASDAQ NASDAQ’s net loss from discontinued operations in 2004 and 2003 represents amounts associated with the disposal of NASDAQ Europe and IndigoMarkets Ltd. As a result of its strategic review, NASDAQ supported the closing of the market operated by NASDAQ Europe. These operations were wound down pursuant to a transition plan approved by the Belgian Banking and Finance Commission. As NASDAQ Europe was winding down its market operations, NASDAQ reached an agreement to transfer all of NASDAQ’s shares in NASDAQ Europe to one of the original investors in NASDAQ Europe. The transfer of shares was completed in December 2003. NASDAQ made a similar decision to discontinue operations in IndigoMarkets Ltd. In 2004, NASDAQ released a reserve previously held to satisfy any potential claims against NASDAQ associated with the wind-down of NASDAQ Europe. See Note 16, “Discontinued Operations,” to the consolidated financial statements for further discussion. CUMULATIVE EFFECT OF A CHANGE IN ACCOUNTING PRINCIPLE In June 2003, the Emerging Issues Task Force finalized EITF No. 00-21, which became effective for NASD’s consolidated financial statements on January 1, 2004. This accounting pronouncement requires revenue arrangements be reviewed to determine (a) how the arrangement consideration should be measured, (b) whether the arrangement should be divided into separate units of NASD 2 004 ANNUAL FINANCIAL REPORT 9
  11. 11. accounting, and (c) how the arrangement consideration should be allocated among the separate units of accounting. Once each element of a revenue arrangement has been identified, EITF No. 00-21 requires companies to recognize the revenue for such element in accordance with existing accounting principles generally accepted in the United States. EITF No. 00-21 does not address when the criteria for revenue recognition are met or provide guidance on the appropriate revenue recognition convention for a given unit of accounting. NASD performed a comprehensive review of all revenue arrangements and concluded that this new accounting pronouncement was applicable to NASD’s registration and dispute resolution fees. As a result of this implementation, NASD changed its method of accounting for revenue recognition for the initial fee component of first year registration fees and amounts collected on open dispute resolution cases. As part of this implementation, NASD has begun deferring and amortizing these elements over an estimated customer relationship period. With this change, NASD recognized a one-time cumulative effect of a change in accounting principle as of January 1, 2004 of a combined $(58.3) million. The impact to 2004 revenues for registrations and dispute resolution fees was not significant. L I Q U I D I T Y A N D C A P I T A L RE S O U R C E S Consistent with the Company’s operation of its business segments as separate stand-alone companies each with its own corporate governance, NASD and NASDAQ separately manage their liquidity and capital resources. Each segment’s Board has approved its respective investment policies for internally and externally managed portfolios. NASD NASD’s investment policy has been developed based on best practices as applied to its investment objectives. The NASD Investment Committee, whose members have extensive background and experience in the investment community, provides overall guidance and advice in determining the appropriate policy, guidelines, and allocation for these investments. NASD engages an investment consultant to support the Investment Committee in the areas of policy and guidelines, and to monitor the performance of the portfolio and investment managers, including periodic selection and evaluation of asset managers. The goal of NASD’s investment policy is to generate long-term returns to be used to support NASD operations for the benefit of investors and members, to preserve the real purchasing power of those funds for future contingencies, and to maintain financial balance sheet strength. Portfolio returns may be used for funding current operating budget needs, maintaining real purchasing power for future contingencies, or for other strategic or operational purposes. NASD’s targeted investment portfolio allocations are 50 to 65 percent equities, 20 to 30 percent fixed income, and 15 to 20 percent alternative investments. NASDAQ The NASDAQ Board of Directors separately reviews and approves the investment policy for NASDAQ and its subsidiaries. The goal of NASDAQ’s investment policy is to maintain adequate liquidity at all times, to fund current budgeted operating and capital requirements and to maximize returns. All securities must meet credit rating standards as established by the policy. The investment duration must not exceed 18 months. Beginning October 2003, the policy prohibits the purchasing of equity securities. CASH FLOWS Both NASD and NASDAQ rely on cash flows from operations to provide working capital for current and future operations. The Company’s net cash provided by operating activities was $156.2 million and $241.1 million for 2004 and 2003, respectively. Net cash used in investing and financing activities by the company in 2004 and 2003 was a combined $365.1 million and $240.3 million, respectively. 10 NASD 2004 ANNUAL FINANCIAL REPORT
  12. 12. See table below for total cash flows by segment between years: YEARS ENDED DECEMBER 31, 2004 2003 NASD NASDAQ Total NASD NASDAQ Total (in millions) Operating: Continuing $ 46.5 $ 107.5 $ 154.0 $158.5 $145.8 $304.3 Discontinued operations (7.4) 9.6 2.2 (22.7) (40.5) (63.2) Total operating 39.1 117.1 156.2 135.8 105.3 241.1 Investing (163.6) (201.3) (364.9) (83.1) (0.2) (83.3) Financing 6.3 (6.5) (0.2) 0.6 (157.6) (157.0) Total $ (118.2) $ (90.7) $ (208.9) $ 53.3 $ (52.5) $ 0.8 NASD During 2004, NASD generated net cashflows from continuing operations of $46.5 million due primarily to net income for the year offset by a reduction in the SEC fee payable of $83.9 million, which is due to the rate change by the SEC of the Section 31 assessment by 50.0 percent. NASD incurred investing cash outflows of $163.6 million in 2004, associated with changes in fund managers and the purchase of additional securities as part of the implementation of NASD’s new investment policy, which was approved by the NASD Board in early 2004. Also included in investing cash outflows were capital expenditures of $28.5 million in 2004 related primarily to the acquisition of storage, servers, and backup equipment associated with the upgrade of NASD’s disaster recovery environment, as well as capitalized software development costs and minor building enhancements. In 2003, capital expenditures were $19.2 million. Financing cash flows were $6.3 million in 2004. NASD has been able to generate sufficient funds from operations to meet working capital requirements. NASD has a $50.0 million line of credit available through November 2005, had it temporarily needed liquidity to meet its current obligations. The Company believes that the liquidity provided by existing cash and cash equivalents, investments, and cash generated from operations will provide sufficient capital to meet current and future operating requirements. NASD working capital was $995.7 million at December 31, 2004, compared with $961.6 million at December 31, 2003. NASDAQ Cash flows from continuing operations activities totaled $107.5 million in 2004 and $145.8 million in 2003. The decrease in operating cash flows was primarily due to payments for the elimination of non-core product lines, initiatives, and severance. Net cash used in investing and financing activities was $207.8 million in 2004 and $157.8 million in 2003. Capital expenditures for 2004 were $26.0 million compared with $31.6 million in 2003. In 2003, NASDAQ redeemed $150.0 million in Senior Notes, which are included in financing activities. NASD 2004 ANNUAL FINANCIAL REPORT 11
  13. 13. CONTRACTUAL OBLIGATIONS AND CONTINGENT COMMITMENTS The Company has contractual obligations to make future payments under several contracts. A combined summary of those contractual obligations is provided below. CONTRACTUAL OBLIGATIONS AND CONTINGENT COMMITMENTS Less than 1-3 3-5 More than Total 1 Year Years Years 5 Years (in millions) Long-term debt by contract maturity (NASDAQ) $ 265.0 $ – $ 241.5 $ 5.0 $ 18.5 Minimum rental commitments under non-cancelable operating leases, net 396.8 57.8 72.2 50.7 216.1 Minimum rental commitments under capitalized leases 1.6 0.7 0.9 – – Other long-term obligations 204.1 52.6 54.7 45.7 51.1 Total $ 867.5 $ 111.1 $ 369.3 $ 101.4 $ 285.7 Long-term debt represents NASDAQ’s $25.0 million senior note payable and NASDAQ’s $240.0 million convertible subordinated notes. Principal payments on the $25.0 million note are scheduled to begin in 2007 and continue in equal monthly installments until maturity in 2012. The $240.0 million convertible subordinated notes become due in May of 2006. See Note 9, “Long Term Debt,” to the consolidated financial statements for further discussion. Minimum rental commitments under non-cancelable operating leases represent totals of NASD and NASDAQ. The majority of these leases contain escalation clauses based on increases in property taxes and building operating costs. Of the amounts presented, NASD operating lease commitments totaled $153.7 million and NASDAQ commitments were $243.1 million. Commitments under capitalized leases are solely attributable to NASD. Other long-term obligations reflect NASD’s information and technology services agreement with EDS, NASDAQ’s global services agreement with MCI, and contracts between Brut and SunGard for on-line processing, hosting, and other related services. NASDAQ RESTRUCTURING NASD and NASDAQ are currently awaiting the SEC’s decision on Exchange Registration for NASDAQ. Upon Exchange Registration, NASD will no longer exert voting control over NASDAQ and, as such, NASD expects that it will cease to consolidate NASDAQ. The following discussion details steps taken to date in the disposition of NASDAQ and the impact on the consolidated operations of the Company. Previous NASD transactions in NASDAQ stock include Phase I and Phase II sales of NASDAQ common shares and warrants in 2000 and 2001. On May 3, 2001, NASD further decreased its ownership through a two-part transaction, which resulted in the issuance of convertible debt by NASDAQ to the private equity firm of Hellman & Friedman, and the subsequent repurchase of shares by NASDAQ from NASD. In March 2002, NASD sold 33.8 million shares of NASDAQ common stock to NASDAQ, reducing its ownership of NASDAQ to 55 percent prior to the exercise of warrants. Assuming the full exercise of all warrants purchased in Phase I and II of the NASDAQ restructuring, this transaction effectively reduced NASD’s ownership of NASDAQ common shares to zero on a fully diluted basis. In exchange for the shares sold, NASDAQ paid NASD $305.2 million in cash, issued 1,338,402 shares of Series A Cumulative Preferred Stock, and one share of Series B Preferred Stock. 12 NASD 2004 ANNUAL FINANCIAL REPORT
  14. 14. With its 54.7 percent ownership and one share of Series B Preferred Stock, NASD continues to exert voting control over NASDAQ and therefore continues to consolidate NASDAQ’s operations under accounting principles generally accepted in the United States. NASDAQ applied for registration as an exchange with the SEC in March 2001. If Exchange Registration is approved, warrant holders will have the right to direct the voting of the shares of NASDAQ common stock underlying the unexercised and unexpired warrants. At that time, NASD will no longer exert voting control and will cease to consolidate NASDAQ’s operations in the Company’s consolidated financial statements. The table below summarizes the effect of all NASD and NASDAQ transactions in NASDAQ stock during the period June 2000 to December 2004. EFFECT OF NASDAQ RESTRUCTURING ACTIVITIES (DOLLARS IN MILLIONS) NASDAQ (Increase) NASD Fully Shares Increase in Decrease in Ownership Diluted Owned by Consolidated Minority Increase in Consolidated % % NASD Equity Interests Liabilities Cash Proceeds Year Ended 12/31/99—after stock split 100.0% 100.0% 100,000,000 $ – $ – $ – $ – Cumulative Activity ‘00 & ‘01 (31.0)% (74.7)% (23,005,129) (247.5) (140.6) (368.6) 756.7 Year Ended 12/31/01 69.0% 25.3% 76,994,871 (247.5) (140.6) (368.6) 756.7 NASDAQ Share Buyback— March 2002 *** (13.5)% (25.3)% (33,768,895) (122.9) 122.9 – – Other NASDAQ & Warrant Exercises (0.3)% – (20,830) (1.0) (1.2) – 2.2 Ending Balance/Cumulative Impact-Year Ended 12/31/02 55.2% – 43,205,146 (371.4) (18.9) (368.6) 758.9 Warrant Exercises & Expirations – 13.7% (15,000) – – – 0.2 Other NASDAQ (0.2)% – – (0.8) (0.7) – 1.5 Ending Balance/Cumulative Impact-Year Ended 12/31/03 55.0% 13.7% 43,190,146 (372.2) (19.6) (368.6) 760.6 Warrant Exercises & Expirations – 13.7% (6,750) – – – 0.1 Other NASDAQ (0.3)% (0.1) – (1.3) (1.0) – 2.3 Ending Balance/Cumulative Impact-Year Ended 12/31/04 54.7% 27.3% 43,183,396 (373.5) (20.6) (368.6) 763.0 Secondary Offering—February 2005 (21.0)% (21.0)% (16,586,980) (135.2) (5.5) – 140.7 Year-Ended 12/31/04—Proforma 33.7% 6.3% 26,596,416 $ (508.7) $ (26.1) $ (368.6) $ 903.7 Cash Proceeds—NASD * $ 871.8 Cash Proceeds—NASDAQ ** 31.9 Total Cash Proceeds $ 903.7 * Reflects the effect of two NASDAQ buybacks of its shares from NASD amounting to $240.0 million (the Hellman & Friedman transaction in 2001) and $305.2 million (the March 2002 transaction). ** Reflects the $240.0 million as a pass through and the $305.2 million as a payment to NASD out of proceeds received during Phase I and II. *** In connection with the March 2002 share buyback NASD also received 1,338,402 shares of Series A Cumulative Preferred Stock and one share of Series B Preferred Stock. NASD 2 004 ANNUAL FINANCIAL REPORT 13
  15. 15. Warrants to purchase NASDAQ common shares are exercisable in four annual tranches. As of December 31, 2004, the first two warrant tranches have expired with only 42,580 warrants having been purchased through the exercise of warrants. The third warrant tranche is set to expire on June 27, 2005 and the final warrant tranche is due to expire on June 27, 2006. Exercise prices for the third and fourth warrant tranches are $15 and $16 per share, respectively. On September 30, 2004, NASD waived a portion of the dividend on the Series A Cumulative Preferred Stock for the third quarter of 2004 of $2.5 million and accepted an aggregate amount of $1.0 million (calculated based on an annual rate of 3.0 percent) as payment in full of the dividend for this period. On November 29, 2004, NASD entered into an exchange agreement with NASDAQ pursuant to which NASD exchanged 1,338,402 shares of NASDAQ’s Series A Cumulative Preferred Stock, for 1,338,402 shares of newly issued Series C Cumulative Preferred Stock. The Series C Cumulative Preferred Stock accrues quarterly dividends at an annual rate of 3.0 percent for all periods until July 1, 2006 and at an annual rate of 10.6 percent for periods thereafter. NASD also may be entitled to an additional payment in certain circumstances, which may not exceed $16.3 million in aggregate depending on the amount of time the Series C Cumulative Preferred Stock is outstanding and the market price of NASDAQ’s common stock at the time NASDAQ redeems the Series C Cumulative Preferred Stock. Shares of Series C Cumulative Preferred Stock do not have voting rights, except for the right as a class to elect two new directors to the Board of Directors any time distributions on the Series C Cumulative Preferred Stock are in arrears for four consecutive quarters and as otherwise required by Delaware law. On February 15, 2005, NASDAQ completed an underwritten secondary offering of 16,586,980 shares of common stock owned by NASD and an additional 3,246,536 shares of common stock owned by certain selling stockholders who purchased the shares in NASDAQ’s private placements in 2000 and 2001. NASDAQ, its officers, or other employees did not sell any shares in the secondary offering. NASD received net proceeds of $140.7 million and recognized a gain on the sale of subsidiary stock of $135.1 million. As of February 15, 2005, NASD owned 33.7 percent of NASDAQ’s common stock, 100.0 percent of NASDAQ Series C Cumulative Preferred Stock, and 100.0 percent of NASDAQ Series B Preferred Stock. Due to the voting rights of the Series B Preferred Stock, NASD will continue to consolidate NASDAQ. Q U A N T I T A T I V E A N D Q U A L I T A T I V E D I S C L O S U R E A B O U T MA R K E T R I S K Market risk represents the risks of changes in value of a financial instrument, derivative or non-derivative, caused by fluctuations in interest rates, foreign exchange rates, and equity prices. As of December 31, 2004, investments in the Company’s consolidated financial statements consisted of equities, U.S. Treasury securities, obligations of U.S. Government-sponsored enterprises, and other financial instruments. The Company’s primary market risk is with respect to its investment portfolio and is associated with fluctuations in the equities markets, as well as fluctuations in interest rates and the effects that both types of fluctuations may have on its investment portfolio and outstanding debt. NASDAQ’s investment portfolio is held primarily in investments with maturities averaging less than one year and NASDAQ’s debt obligations generally specify a fixed interest rate. Therefore, NASDAQ does not believe that a 100 basis-point fluctuation in market interest rates will have a material effect on the carrying value of the investment portfolio or earnings or cash flows. NASD’s investment portfolio also contains fixed income securities. However, NASD’s fixed income securities have a longer maturity than NASDAQ’s, with a duration, or weighted average maturity of cash flows, of approximately 3.0 years as of December 31, 2004. Duration is a measure of the sensitivity of a fixed income portfolio to a change in interest rates: for every 100 basis point change in interest rates, a portfolio with a duration of 3.0 years is expected to change inversely by 3.0 percent. NASD believes that any decline in the value of its fixed income securities due to a 100 basis point increase in interest rates should be largely offset by the portfolio’s yield of approximately 3.8 percent. 14 NASD 2004 ANNUAL FINANCIAL REPORT
  16. 16. NASD maintains a portion of its portfolio in equity securities, which have been more sensitive to market fluctuations. NASD reviews its investment portfolio for other-than-temporary declines on a quarterly basis. Based on these reviews, NASD recorded impairment charges for other-than-temporary declines of $3.1 million and $0.1 million in 2004 and 2003, respectively. NASD management believes that other-than-temporary fluctuations in market indices could have a significant impact on NASD’s investment portfolio and earnings and cash flows. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The preparation of the Company’s financial statements in conformity with generally accepted accounting principles requires management to adopt accounting principles and make estimates and judgments to develop amounts reported in the financial statements and accompanying notes. The Company periodically reviews the application of its accounting policies and evaluates the appropriateness of the estimates that are required to prepare the financial statements. The Company believes its estimates and judgments are reasonable; however, actual results and the timing of recognition of such amounts could differ from those estimates. The Company’s significant accounting policies are described in Note 2, “Summary of Significant Accounting Policies,” to the consolidated financial statements. The following provides information about the Company’s critical accounting policies, which are defined as those that are reflective of significant judgments and uncertainties, and potentially result in materially different results under different assumptions and conditions. At the consolidated level, the Company has determined that the critical accounting policies are those that cover investments, revenue recognition, software costs, impairment of long-lived assets, and pension benefits. INVESTMENTS Under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” management determines the appropriate classification of investments at the time of purchase. Investments for which the Company does not have the intent or ability to hold to maturity are classified as “available-for-sale” and are carried at fair value, with any unrealized gains and losses, net of tax, reported as a separate component of members’ equity. Investments for which the Company has the intent and ability to hold to maturity are classified as “held-to-maturity” and are carried at amortized cost. The amortized cost of debt securities classified as held-to-maturity is adjusted for amortization of premiums and accretion of discounts. Fair value is determined based on quoted market prices when available, or if quoted market prices are not available, on discounted expected cash flows using market rates commensurate with the credit quality and maturity of the investment. Realized gains and losses on sales of securities are included in earnings using the average cost method. Amounts due to or from the custodial agent relate to security trades executed prior to the balance sheet date but not yet settled. The Company reviews its investments quarterly to determine whether a decline in fair value below cost basis is other-than- temporary. If the decline in the fair value is judged to be other-than-temporary, the cost basis of the investment is written down to fair value, the amount of the write-down is charged to earnings, and a new cost basis for the security is established. REVENUE RECOGNITION AND COST OF REVENUE Market services include the NASDAQ Market Center and NASDAQ market services subscriptions revenues. NASDAQ Market Center revenues are variable, based on service volumes, and recognized as transactions occur. NASDAQ market services subscriptions revenues are based on the number of presentation devices in service and quotes delivered through those devices. NASDAQ market services subscriptions revenues are recognized in the month that information is provided and are recorded net of amounts due NASD 2 004 ANNUAL FINANCIAL REPORT 15
  17. 17. under revenue sharing arrangements with market participants. Pursuant to EITF No. 99-19, “Reporting Revenues Gross vs. Net,” execution revenues from transactions executed through Brut are recorded on a gross basis in revenues. Expenses, such as the liquidity rebate payments, are recorded in cost of revenues as Brut acts as principal. NASDAQ’s other execution revenues will continue to be reported net of the liquidity rebate as NASDAQ does not act as principal. Issuer services consist primarily of annual listing fees, initial listing (IL) fees and listing of additional shares (LAS) fees on The NASDAQ Stock Market. Annual listing service revenues are recognized ratably over the following 12-month period. IL and LAS fees are recognized on a straight-line basis over estimated customer relationship periods. NASDAQ receives license fees for its trademark licenses related to the QQQ and other financial products linked to NASDAQ indices issued in the U.S. and abroad. These revenues are recognized as earned. Regulatory fees represent fees to fund NASD’s member regulatory activities, including the supervision and regulation of members through examinations, processing of membership applications, financial monitoring, policy, rulemaking, interpretive, and enforcement activities. Regulatory fees are recorded net of any member rebates. Regulatory fees include a trading activity fee, gross income assessment, personnel assessment, and branch office assessment. The trading activity fee is assessed on the sell side of all member transactions in all covered securities regardless of where the trade is executed and is assessed directly to the firm responsible for clearing the transaction on behalf of the member firm. The trading activity fee is recognized as the transaction occurs. Gross income assessments, personnel assessments, and branch office assessments represent annual fees charged to member firms and representatives and are recognized ratably over the annual period to which they relate. User fees consist of fees charged for initial and annual registrations, qualification exams, fees associated with NASD sponsored meetings and conferences, and charges related to the review of advertisements and corporate filings. Registration fees include both an initial and annual fee charged to all NASD-registered representatives. The initial fee is recognized over the estimated customer relationship period and the annual fee over the related annual period. Qualification fees consist of examination and continuing education fees, which are recognized as the exam is given or continuing education program is held. Advertising represents fees charged for the review of NASD member firms’ communications to ensure that they are fair, balanced, and not misleading. Advertising fees are recognized as revenue as the review is completed. Corporate financing consists of fees charged by NASD for reviewing proposed public offerings and are recognized as the review is completed. Dispute resolution fees consist of fees earned during the arbitration and mediation processes. Fees on open cases are recognized as revenue over the average life of a case. Upon closing of a case, a final billing is prepared and any unpaid fees are recognized as revenue at that time. Also included in dispute resolution fees are mediation fees, SRO annual fees for forum services, neutral training fees, and other fees, which are recognized either when the cash is received or when the service is provided. Transparency services for NASD represent fees charged through NASD’s TRACE and ADF. TRACE represents fees charged on secondary market transactions in eligible fixed income securities reported to NASD, TRACE system-related fees, and TRACE market data fees. ADF is a facility for posting quotes, and reporting and comparing trades. TRACE and ADF fees are recognized as the transactions occur. Contract service fees represent amounts charged by NASDR for regulatory services provided under contractual arrangements and are recognized as revenue as the regulatory service is provided. NASD, as an SRO, pays certain fees and assessments to the SEC pursuant to Section 31 of the Securities and Exchange Act of 1934. These fees are designed to cover costs incurred by the government in the supervision and regulation of securities markets and securities professionals and are based on a percentage of the total dollar value of securities sold in The NASDAQ Stock Market, the ADF, and the over-the-counter (OTC) Bulletin Board. NASD remits these fees to the U.S. Treasury semiannually in March and September. In 2004, the SEC adopted new rules under Section 31 and provided SROs additional guidance as to how the SEC charges SROs for these fees, which affected NASD’s accounting treatment for such fees in its consolidated financial statements. 16 NASD 2004 ANNUAL FINANCIAL REPORT
  18. 18. NASD recovers the cost of the SEC’s fees and assessments through an activity assessment billed to securities firms based on the total dollar value of securities sold in The NASDAQ Stock Market, the ADF, and the OTC Bulletin Board. The assessments billed to securities firms are recognized when the transactions occur. Beginning in 2004, NASD reported the activity assessment on a gross basis within revenues in accordance with EITF No. 99-19. Amounts due to the SEC are reported as a cost of revenue. The effect of this change had no impact on NASD’s consolidated net income. Fines represent sanctions for rule violations. Commencing in 2004, fines are recognized when the fine is assessed. SOFTWARE COSTS Significant purchased application software, and operational software that is an integral part of computer hardware, are capitalized and amortized using the straight-line method over their estimated useful lives, generally two to seven years. All other purchased software is charged to expense as incurred. In accordance with Statement of Position No. 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use,” the Company capitalizes internal computer software development costs incurred during the application development stage. Computer software costs incurred prior to or subsequent to the application development stage are charged to expense as incurred. IMPAIRMENT OF LONG-LIVED ASSETS The Company reviews its long-lived assets for impairment in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” In the event that facts and circumstances indicate that long-lived assets or other assets may be impaired, an evaluation of recoverability would be performed. If an evaluation were required, the estimated future undiscounted cash flows associated with the asset would be compared to the asset’s carrying amount to determine if a write-down is required. If impairment were indicated, the Company would prepare a discounted cash flow analysis to determine the amount of the impairment. PENSION BENEFITS The Company provides three non-contributory defined benefit pension plans for the benefit of eligible employees of its subsidiaries. The non-contributory defined benefit plan consists of a funded Employee Retirement Plan and two unfunded Supplemental Executive Retirement Plans. Several statistical and other factors, which attempt to anticipate future events, are used in calculating the expense and liability related to the plans. Key factors include assumptions about the expected rates of return on plan assets and discount rates as determined by the Company, within certain guidelines. The Company considers market conditions, including changes in investment returns and interest rates, in making these assumptions. The Company determines the long-term rate of return based on analysis of historical and projected returns as prepared by the Company’s actuary and external investment consultant. The discount rate used in the calculations is tracked to changes in Moody’s Aa bond ratings. The Company’s Pension Plan Committee approves both the expected long-term rate of return and the discount rate assumptions. Unrecognized actuarial gains and losses are being recognized over time in accordance with SFAS No. 87, “Employers Accounting for Pensions.” Unrecognized actuarial gains and losses arise from several factors including experience and assumption changes in the obligations, and from the difference between expected returns and actual returns on plan assets. The actuarial assumptions used by the Company in determining its pension benefits may differ materially from actual results due to changing market conditions and economic conditions, as well as early withdrawals by terminating plan participants. While the Company believes that the assumptions used are appropriate, differences in actual experience or changes in assumptions may materially affect the Company’s financial position or results of operations. NASD 2 004 ANNUAL FINANCIAL REPORT 17
  19. 19. RECENT ACCOUNTING PRONOUNCEMENTS In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123 (revised 2004), “Share-Based Payment” (SFAS No. 123(R)), which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 123(R) supersedes Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees,” and amends SFAS No. 95, “Statement of Cash Flows.” Generally the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires NASDAQ to expense, in the consolidated statements of income, all share-based payments to employees, including grants of employee stock options, based on their fair values. This cost will be recognized over the vesting period of the grants. Pro forma disclosure will no longer be an alternative. NASDAQ cannot predict the impact of adoption of SFAS No. 123(R) because the impact will depend on the levels of share-based payments granted in the future. However, had NASDAQ adopted SFAS No. 123(R) in prior periods, the impact of that standard would have approximated the impact of SFAS No. 123 as described in the disclosure of pro forma net income and earnings per share in Note 12, “NASDAQ Stock Compensation, Stock Awards, and Capital Stock,” to the consolidated financial statements. In April 2005, the SEC announced the adoption of a new rule allowing companies to implement SFAS No. 123(R) at the beginning of their next fiscal year that begins after June 15, 2005. In March 2004, the Emerging Issues Task Force issued EITF No. 03-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments,” which provides new guidance for assessing impairment losses on debt and equity investments. Additionally, EITF No. 03-1 includes new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB voted to delay the accounting provisions of EITF No. 03-1; however, the disclosure requirements remain effective and have been adopted for the Company’s year ended December 31, 2004 financial statements and are included in Note 6 “Investments” to the consolidated financial statements. Once issued, the Company will evaluate the impact of adopting the accounting provisions of EITF No. 03-01. 18 NASD 2004 ANNUAL FINANCIAL REPORT
  20. 20. CERTIFICATION FOR 2004 ANNUAL FINANCIAL REPORT We, Robert R. Glauber and Todd T. Diganci, certify that: 1. We have reviewed this annual financial report of the National Association of Securities Dealers, Inc. (NASD); 2. The purpose of this report is principally to set forth management’s report on financial operations with respect to NASD during the years ended December 31, 2004, together with the consolidated financial statements of NASD as of and for the year ended December 31, 2004 and 2003, and this report is not intended to comply with the substantive or form requirements for periodic reports under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and the rules and regulations promulgated thereunder (the “Exchange Act Rules and Regulations”) required of issuers of securities subject to the periodic reporting requirements under Sections 12, 13 and 15 of the Exchange Act of 1934 and the related Exchange Act Rules and Regulations; 3. Based on our knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 4. Based on our knowledge, the financial statements and other financial information set forth under the caption “Management Report on Financial Operations”, fairly present in all material respects the financial condition, results of operations and cash flows of NASD as of, and for, the periods presented in this report; 5. NASD has established disclosure controls and procedures to ensure that material information relating to NASD, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; 6. NASD has carried out its evaluation of the effectiveness of the design and operation of NASD’s disclosure controls and procedures as of December 31, 2004. Based upon that evaluation, we have concluded that the disclosure controls and procedures are effective; 7. We have disclosed, based on NASD’s most recent evaluation of internal control over financial reporting, to NASD’s auditors and the Audit Committee of NASD’s Board of Directors: a) Any significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect NASD’s ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in NASD’s internal control over financial reporting. Date: May 17, 2005 Robert R. Glauber Chairman and CEO Todd T. Diganci Executive Vice President and C FO NASD 2 004 ANNUAL FINANCIAL REPORT 19
  21. 21. AUDIT COMMITTEE REPORT In accordance with its written Charter adopted by the Board of Governors, the Audit Committee of the Board of Governors assists the Board in fulfilling its responsibility for oversight of the quality and integrity of the accounting, auditing, and financial reporting practices of NASD. Each member of the Committee is an independent director as defined by SEC Rule 10A-3 under The Securities and Exchange Act of 1934, Listing Standards Relating to Audit Committees. In addition, the Audit Committee and Board of Governors have determined that James E. Burton and Charles A. Bowsher are audit committee financial experts, as defined by the SEC. The Charter gives the Audit Committee responsibility for monitoring the independence of the independent auditors and recommending the appointment of the independent auditors for approval by the Board of Governors, and makes clear that the independent auditors are accountable to the Audit Committee and the Board of Governors, as representatives of the members and the public. In all respects, the Charter complies with standards applicable to publicly owned companies. In addition, the Charter and the By-laws of NASD make the Director of Internal Audit directly responsible to the Audit Committee. (The Charter for the NASD Audit Committee is available on the Internet at the following URL: http://www.nasd.com/auditcommittee.) During 2004, the Committee met seven times, with the Committee members having a 94% attendance rate. In discharging its oversight responsibility, the Audit Committee reviewed the assessments of audit risk and the audit plans of both the independent and internal auditors. The Audit Committee also discussed with management, the internal auditors, and the independent auditors the quality and adequacy of NASD’s internal controls and the internal audit organization, responsibilities, budget, and staffing. The Audit Committee obtained a written statement from the independent auditors describing all relationships with NASD. The Audit Committee discussed those relationships and satisfied itself that none of the relationships were incompatible with the auditors’ independence. The Committee has reviewed and approved all services performed by NASD’s independent auditors, Ernst and Young LLP, and the associated fees, before initiation of each engagement. Such services and fees are summarized in the following table: INDEPENDENT PUBLIC ACCOUNTANT (IPA) FEES NASD (6) NASDAQ (5) Amex (6) Total 2004 2003 2004 2003 2004 2003 2004 2003 Audit services (1) $ 656,440 $ 571,197 $ 2,307,100 $ 1,857,159 $ 258,000 $ 241,500 $ 3,221,540 $ 2,669,856 Audit-related services (2) 447,784 329,251 278,314 191,200 8,456 49,275 734,554 569,725 Tax services (3) 17,188 36,441 100,000 435,325 – – 117,188 471,766 Other services (4) – – – 6,900 – – – 6,900 Total $ 1,121,412 $ 936,889 $ 2,685,414 $ 2,490,584 $ 266,456 $ 290,775 $ 4,073,282 $ 3,718,247 (1) Audit services for NASD and Amex represent fees for the year-end financial statement audits. Audit services for NASDAQ represent fees associated with the audit, inclusive of international entities, of NASDAQ’s annual financial statements, the review of NASDAQ’s quarterly reports on Form 10-Q, and accounting consultations on matters addressed during the audit or interim review. In addition, NASDAQ audit fees for 2004 include attestation procedures in connection with the internal control reporting requirements of Section 404 of the Sarbanes-Oxley Act of 2002. (2) Audit-related services in 2004 and 2003 for NASD reflect fees associated with special purpose audits and agreed-upon procedures such as IARD, CRD, employee benefit plans, as well as audit related services associated with the planned disposition of Amex and separation from NASDAQ. Also included in NASD audit-related services are advisory fees associated with the initial phases of NASD’s implementation of the principles embodied in Section 404. NASDAQ audit-related fees represent assurance and employee benefit plan audits. NASDAQ audit-related services also include internal control reviews including reviewing Section 404 internal control program design. 20 NASD 2004 ANNUAL FINANCIAL REPORT
  22. 22. (3) Tax services represent fees related to tax compliance, advice, and planning. (4) For 2003, other services for NASDAQ represent client advisory services and products. (5) NASDAQ IPA services and fees are separately reviewed and approved by the NASDAQ Audit Committee. The NASD Audit Committee has oversight of the NASDAQ Audit Committee, but does not review actions taken with respect to the approval of IPA fees. NASDAQ fees exclude services provided to non-profit entities of The Nasdaq Stock Market, Inc., services provided in relation to NASDAQ’s role as the Securities Information Processor under the Unlisted Trading Privileges Plan and the audit of the NASDAQ-100 Trust, Series 1, the trust for the NASDAQ- 100 Index Tracking Stock, also known as QQQ. NASDAQ also incurred fees payable to Deloitte & Touché, LLP (Deloitte & Touché) for fiscal year ended 2004, totaling $226,750. On September 7, 2004, NASDAQ completed its acquisition of Toll Associates LLC and affiliated entities from SunGard Data Systems Inc., which includes Brut, LLC. These fees represent audit fees on the consolidated financial statements of Toll Associates as of December 31, 2004 and for the period September 7, 2004 through December 31, 2004. Deloitte & Touché was the independent registered public accounting firm for Toll Associates before the acquisition and, given their historical knowledge, the NASDAQ Audit Committee chose to continue the relationship through the remainder of 2004. (6) NASD and Amex fees for 2004 are based on fees approved by NASD’s Audit Committee as of April 20, 2005. The 2004 audit services and audit-related services include estimates to complete the current work in process. Fees included in 2003 were generally paid between July 1, 2003 and June 30, 2004. NASD 2003 fees have been updated from the prior year report to reflect final amounts paid for the 2003 approved services. The Audit Committee discussed and reviewed with the independent auditors all communications required by generally accepted auditing standards and, with and without management present, discussed the results of the independent auditors’ examination of the financial statements. Based on those discussions, the Audit Committee recommended to the Board of Governors that NASD’s audited financial statements be included in the Annual Report for the year ended December 31, 2004. Members of the Audit Committee: James E. Burton, Chair John W. Bachmann M. LaRae Bakerink Charles A. Bowsher Joel Seligman May 9, 2005 NASD 2 004 ANNUAL FINANCIAL REPORT 21
  23. 23. REPORT OF INDEPENDENT AUDITORS BOARD O F GOVERNORS NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC. We have audited the accompanying consolidated balance sheets of the National Association of Securities Dealers, Inc. (NASD) as of December 31, 2004 and 2003, and the related consolidated statements of income, changes in members’ equity, and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the consolidated financial statements of Toll Associates LLC, a partially owned subsidiary, which statements reflect 10.3% of consolidated total assets at December 31, 2004 and 4.6% of total consolidated revenues for the year then ended. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for Toll Associates LLC, is based solely on the report of other auditors. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits, and the report of other auditors, provide a reasonable basis for our opinion. In our opinion, based on our audits and the report of other auditors, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of NASD at December 31, 2004 and 2003, and the consolidated results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States. As discussed in Note 5 to the consolidated financial statements, in 2004 the Company changed its method of accounting for certain registration and arbitration revenues. McLean, Virginia April 29, 2005 22 NASD 2004 ANNUAL FINANCIAL REPORT
  24. 24. NASD CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS) DECEMBER 31, 2004 2003 Assets Current assets: Cash and cash equivalents $ 123,834 $ 332,784 Investments: Available-for-sale, at fair value 1,391,859 1,309,307 Held-to-maturity, at amortized cost 28,600 23,765 Receivables, net 151,830 175,254 Receivables from related parties 4,946 – Deferred tax assets 24,209 40,460 Other current assets 21,056 22,728 Current assets—discontinued operations – 120,511 Total current assets 1,746,334 2,024,809 Held-to-maturity investments, at amortized cost 2,008 4,506 Property and equipment: Land, buildings, and improvements 172,350 169,216 Data processing equipment and software 369,239 529,522 Furniture, equipment and leasehold improvements 264,442 305,073 806,031 1,003,811 Less accumulated depreciation and amortization (492,186) (605,661) Total property and equipment, net 313,845 398,150 Non-current deferred tax assets 48,765 109,479 Note receivable from Amex 25,000 – Goodwill 141,381 – Intangible assets, net 44,260 5,322 Other assets 33,125 34,235 Non-current assets—discontinued operations – 32,785 Total assets $ 2,354,718 $ 2,609,286 See accompanying notes. NASD 2 004 ANNUAL FINANCIAL REPORT 23
  25. 25. NASD CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS) DECEMBER 31, 2004 2003 Liabilities and members’ equity Current liabilities: Accounts payable and accrued expenses $ 65,026 $ 65,748 SEC fee payable 68,275 152,198 Accrued personnel and benefit costs 145,557 134,855 Deferred revenue 137,523 96,546 Deposits and renewals 63,032 67,220 Capital lease obligation 737 2,320 Due to custodial agent 17,696 124,973 Due to related parties 450 – Other current liabilities 70,043 126,559 Current liabilities—discontinued operations – 102,924 Total current liabilities 568,339 873,343 Accrued pension and other post retirement benefit costs 57,794 41,307 Long-term debt 265,000 265,000 Non-current deferred tax liabilities 29,514 78,317 Non-current capital lease obligation 868 1,654 Deferred revenue 107,061 84,703 Warrants to purchase NASDAQ stock from NASD 3,836 7,744 Other liabilities 49,343 46,990 Non-current liabilities—discontinued operations – 41,280 Total liabilities 1,081,755 1,440,338 Minority interest 11,938 12,034 Commitments and contingencies Members’ equity 1,194,043 1,120,191 Unrealized gain on available-for-sale investments 74,131 39,442 Foreign currency translation 988 875 Minimum pension liability (8,137) (3,594) Total members’ equity 1,261,025 1,156,914 Total liabilities and members’ equity $ 2,354,718 $ 2,609,286 See accompanying notes. 24 NASD 2004 ANNUAL FINANCIAL REPORT
  26. 26. NASD CONSOLIDATED STATEMENTS OF INCOME (DOLLARS IN THOUSANDS) YEARS ENDED DECEMBER 31, 2004 2003 Revenues Operating revenues: Market services $ 332,540 $ 383,580 Issuer services 201,458 204,166 Regulatory fees, net of member rebates of $30,000 in 2004 and $25,000 in 2003 222,844 174,225 User fees 137,277 128,382 Dispute resolution fees 80,181 75,453 Transparency services 14,736 21,139 Contract service fees 4,693 2,570 Other 2,321 4,658 Total operating revenues 996,050 994,173 Activity assessment 230,853 365,803 Fines 114,414 33,329 Total revenues 1,341,317 1,393,305 Cost of revenues: SEC activity remittance (230,853) (365,803) Other (55,845) – Total cost of revenues (286,698) (365,803) Net Revenues 1,054,619 1,027,502 Expenses Compensation and benefits 454,827 427,094 Professional and contract services 139,182 153,376 Computer operations and data communications 123,443 144,712 Depreciation and amortization 115,867 137,300 Occupancy 59,081 61,308 General and administrative 104,354 90,197 Elimination of non-core product lines, initiatives, and severance – 97,910 NASDAQ Japan impairment gain – (5,000) Total expenses 996,754 1,106,897 Net revenues less expenses 57,865 (79,395) Other income (expense) Interest and dividend income 35,348 43,355 Interest expense (11,773) (18,702) Net realized investment gains 25,684 24,327 Gain on NASDAQ warrants 3,909 16,080 Net losses from equity investees – (4,102) Minority interest (expense) benefit (5,149) 47,203 Income before income taxes, discontinued operations, and cumulative effect of change in accounting principle 105,884 28,766 (Provision) benefit for income taxes (749) 21,240 Income from continuing operations 105,135 50,006 Income (loss) from discontinued operations (net of tax expense (benefit) of $5,596 in 2004 and ($12,494) in 2003) 19,698 (107,720) Cumulative effect of change in accounting principle (58,342) – Net income (loss) $ 66,491 $ (57,714) Pro forma net income (loss) assuming the accounting change is applied retroactively $ 124,833 $ (60,840) See accompanying notes. NASD 2 004 ANNUAL FINANCIAL REPORT 25
  27. 27. NASD CONSOLIDATED STATEMENTS OF CHANGES IN MEMBERS’ EQUITY (DOLLARS IN THOUSANDS) Accumulated Other Members’ Comprehensive Equity Income (Loss) Total Balance, January 1, 2003 $ 1,173,487 $ 1,069 $ 1,174,556 Net loss (57,714) (57,714) Unrealized gain on available-for-sale investments, net of tax of $340, net of minority interests of $340 – 34,068 34,068 Foreign currency translation, net of minority interests of $856 – 1,092 1,092 Minimum pension liability, net of tax of $191, net of minority interests of ($135) – 494 494 Comprehensive loss – – (22,060) Increase in equity attributable to the minority interest in preferred stock dividends 3,781 – 3,781 Increase in equity attributable to the issuance of stock by NASDAQ and its subsidiaries, net of minority interest of $684 791 – 791 Decrease in equity attributable to amortization of restricted stock awards by NASDAQ, net of minority interest of $44 (154) – (154) Balance, December 31, 2003 1,120,191 36,723 1,156,914 Net income 66,491 66,491 Unrealized gain on available-for-sale investments, net of tax of $599 net of minority interests of $(409) – 34,689 34,689 Foreign currency translation, net of minority interests of $99 – 113 113 Minimum pension liability, net of tax of $293, net of minority interests of $(201) – (4,543) (4,543) Comprehensive income – – 96,750 Increase in equity attributable to the minority interest in the loss on exchange and accretion of NASDAQ preferred stock 2,191 – 2,191 Increase in equity attributable to the minority interest in preferred stock dividends and distributions to NASD for the NASDAQ insurance agency 3,894 – 3,894 Increase in equity attributable to the issuance of stock by NASDAQ and its subsidiaries, net of minority interest of $1,121 1,154 – 1,154 Increase in equity attributable to amortization of restricted stock awards by NASDAQ, net of minority interest of $100 122 – 122 Balance, December 31, 2004 $ 1,194,043 $ 66,982 $ 1,261,025 See accompanying notes. 26 NASD 2004 ANNUAL FINANCIAL REPORT

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